Short selling a strategy fraught with risk

Short selling is a bet that stocks will go down in price rather than up.

When stocks go up instead of down, short sellers can find themselves squeezed.

This strategy involves unlimited downside risk, so it's not for novices.

Selling stocks short can be an effective method to diversify and hedge against losses in your equity portfolio. But it is a technique that carries great danger, and investors should exercise extreme caution before deploying it.

"Short selling is appropriate for any investor, as long as you know what you're doing and how it works," says Chris Litchfield, a former hedge fund manager in Greenwich, Conn., who has shorted stocks for 35 years.

"When you do it right, it's a good way to reduce your risk, but in the wrong hands, it can be a real serious problem."

Short selling refers to the sale of shares you don't own. After you borrow the stock from a broker, you immediately sell it, hoping the price will then fall. That way, you can buy the stock back -- to return to your lender -- at a lower price than what you sold it for, pocketing the difference as profit.

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The mechanics of short selling

To begin the process, open a margin account at your brokerage firm. The starting sum can be as low as $5,000. Buying on margin means you don't need the full value of the shares you are borrowing in your account. Margin requirements generally range from 30 percent to 50 percent. A 50 percent requirement would mean you can short $10,000 worth of stock with a $5,000 account.

You will pay interest, known as the margin rate, on the money you are borrowing for the shares. How much does it cost when you borrow on margin? One discount brokerage currently charges rates varying from 3.75 percent for borrowings of $500,000 or more to 8.58 percent for borrowings less than $10,000.

Keep in mind that if your short position goes against you -- instead of falling, the stock rises -- your brokerage firm may initiate a margin call. That means you must increase the amount of cash in your account to cover the risk of loss.

You may have to pay an additional fee for shares that are "hard to get," meaning your broker has to go to another institution to borrow them. At one discount brokerage, the fees rise as high as 5 percent, and the fee can change daily. But you usually don't have to pay fees for large-capitalization stocks because they are readily available.

Unlimited downside

The first thing to keep in mind when considering short sales is that your risk is infinitely greater than going long. Going long means buying stock with the hope it will rise in value. "When you buy a stock, you have unlimited upside and a defined downside," notes Robert Luna, CEO of SureVest Capital Management in Phoenix. After all, a stock can't fall in price below zero.

A short position, by contrast, carries the opposite implications. Your gain is limited by the fact that a stock can't fall below zero, and your loss is unlimited because a stock can keep rising forever.

Looking at it another way, in a portfolio holding only long positions, when an individual stock goes against you, it becomes a smaller part of your portfolio, Litchfield explains. But when a short position goes against you, it becomes a larger part of your portfolio.

"That's something that escapes almost every investor, but your margin clerk knows it well and will be the first one to tell you when it's a problem," Litchfield says.

As a result, he and others emphasize that you should keep any short positions small. "If you short 1 percent of your portfolio and lose all of it, then it's not a big deal," says Erik Kobayashi-Solomon, a market strategist for Morningstar research in Chicago. "It becomes more a portfolio management exercise."

Remember that stocks generally drift upward over time, so you don't want to hold your short positions for a long time. "With long positions, you are more likely to buy and hold," says Ethan Anderson, a senior portfolio manager for Rehmann Financial in Grand Rapids, Mich. "But shorts can reverse on you quickly. You can have a squeeze just because shorts are unwinding their positions, even though there's no good news for the company."

A "short squeeze" refers to a situation where traders who have shorted a stock are forced, or squeezed, out of their positions by a rapid rise in the stock's price.

Mutual funds, options

If you're looking for a safer way to gain a short exposure to stocks, you may want to consider long-short mutual funds or options. "The options market is much safer than regular short selling, and long-short funds are safest," says Luna.

As you might guess from the name, long-short funds take short positions as well as long ones. Some long-short funds are market neutral, meaning that short positions exactly balance out long ones. And others take a directional bet on the market. "We like both," Anderson says. If you pick a strong fund, you are unlikely to suffer major losses.

As for options, you can buy a put option on an individual stock or stock index. A put gives you the right, but not the obligation, to sell the stock or index at a preset price. Your maximum loss will be your premium -- the amount you pay for the option. But options have a lot of moving parts, so make sure you do your homework before plunging into them.

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